8 Application: The Costs of Taxation

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1 Seventh Edition Principles of Economics N. Gregory Mankiw Wojciech Gerson ( ) CHAPTER 8 Application: The Costs of Taxation

2 In this chapter, look for the answers to these questions How does a tax affect consumer surplus, producer surplus, and total surplus? What is the deadweight loss of a tax? What factors determine the size of this deadweight loss? How does tax revenue depend on the size of the tax?

3 Review from Chapter 6 A tax drives a wedge between the price buyers pay and the price sellers receive. raises the price buyers pay and lowers the price sellers receive. reduces the quantity bought & sold. These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter. 2

4 The Effects of a Tax Eq m with no tax: Price = P E Quantity = Q E Eq m with tax = $T per unit: P B P E P Size of tax = $T S Buyers pay P B Sellers receive P S Quantity = Q T P S Q T Q E Q 3

5 The Effects of a Tax P Revenue from tax: $T x Q T P B Size of tax = $T S P E P S Q T Q E Q 4

6 The Effects of a Tax Next, we apply welfare economics to measure the gains and losses from a tax. We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. Tax revenue can fund beneficial services (e.g., education, roads, police), so we include it in total surplus. 5

7 The Effects of a Tax Without a tax, P CS = A + B + C PS = + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + + E + F P E A F B C E S Q T Q E Q 6

8 The Effects of a Tax With the tax, CS = A PS = F Tax revenue = B + Total surplus = A + B + + F P B P S P A F B C E S The tax reduces total surplus by C + E Q T Q E Q 7

9 The Effects of a Tax P C + E is called the deadweight loss (WL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. P B P S A F B C E S Q T Q Q E 8

10 About the eadweight Loss Because of the tax, the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades. P B P S P Q T Q E S Q 9

11 ACTIVE LEARNING 1 Analysis of a tax A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and WL. $ P The market for airplane tickets S Q

12 ACTIVE LEARNING 1 Answers to A CS = ½ x $200 x 100 = $10,000 PS = ½ x $200 x 100 = $10,000 Total surplus = $10,000 + $10,000 = $20,000 $ P = P The market for airplane tickets S Q

13 ACTIVE LEARNING 1 Answers to B CS = ½ x $150 x 75 = $5,625 PS = $5,625 Tax revenue = $100 x 75 = $7,500 Total surplus = $18,750 WL = $1,250 $ P B = P S = P A $100 tax on airplane tickets S Q

14 What etermines the Size of the WL? Which goods or services should govt tax to raise the revenue it needs? One answer: those with the smallest WL. When is the WL small vs. large? Turns out it depends on the price elasticities of supply and demand. Recall: The price elasticity of demand (or supply) measures how much Q (or Q S ) changes when P changes. 13

15 WL and the Elasticity of Supply When supply is inelastic, it s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, P Size of tax S and WL is small. Q 14

16 WL and the Elasticity of Supply The more elastic is supply, P the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplusmaximizing quantity, the greater the WL. Size of tax S Q 15

17 WL and the Elasticity of emand P Size of tax S When demand is inelastic, it s harder for consumers to leave the market when the tax raises P B. So, the tax only reduces Q a little, Q and WL is small. 16

18 WL and the Elasticity of emand P Size of tax S Q The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplusmaximizing quantity, and the greater the WL. 17

19 ACTIVE LEARNING 2 Elasticity and the WL of a tax Would the WL of a tax be larger if the tax were on: A. Breakfast cereal or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants?

20 ACTIVE LEARNING 2 Answers A. Breakfast cereal or sunscreen From Chapter 5: Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger WL than a tax on sunscreen.

21 ACTIVE LEARNING 2 Answers B. Hotel rooms in the short run or long run From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger WL in the long run than in the short run.

22 ACTIVE LEARNING 2 Answers C. Groceries or meals at fancy restaurants From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger WL than a tax on groceries.

23 ACTIVE LEARNING 3 iscussion question The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants. Which should it tax?

24 How Big Should the Government Be? A bigger government provides more services, but requires higher taxes, which cause WLs. The larger the WL from taxation, the greater the argument for smaller government. The tax on labor income is especially important; it s the biggest source of govt revenue. For the typical worker, the marginal tax rate (the tax on the last dollar of earnings) is about 40%. How big is the WL from this tax? It depends on elasticity. 23

25 How Big Should the Government Be? If labor supply is inelastic, then this WL is small. Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage. 24

26 How Big Should the Government Be? Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives: Many workers can adjust their hours, e.g., by working overtime. Many families have a 2 nd earner with discretion over whether and how much to work. Many elderly choose when to retire based on the wage they earn. Some people work in the underground economy to evade high taxes. 25

27 The Effects of Changing the Size of the Tax Policymakers often change taxes, raising some and lowering others. What happens to WL and tax revenue when taxes change? We explore this next. 26

28 WL and the Size of the Tax Initially, the tax is T per unit. P new WL oubling the tax causes the WL to more than double. 2T T initial WL S Q 2 Q 1 Q 27

29 WL and the Size of the Tax Initially, the tax is T per unit. P new WL Tripling the tax causes the WL to more than triple. 3T T initial WL S Q 3 Q 1 Q 28

30 WL and the Size of the Tax Implication When tax rates are low, raising them doesn t cause much harm, and lowering them doesn t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial. WL Summary When a tax increases, WL rises even more. Tax size 29

31 Revenue and the Size of the Tax When the tax is small, increasing it causes tax revenue to rise. P B P B P S P S P 2T T S Q 2 Q 1 Q 30

32 Revenue and the Size of the Tax P P B P B S When the tax is larger, increasing it causes tax revenue to fall. P S P S 3T 2T Q 3 Q 2 Q 31

33 Revenue and the Size of the Tax The Laffer curve shows the relationship between the size of the tax and tax revenue. Tax revenue The Laffer curve Tax size 32

34 Summary A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt. The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (WL) of the tax. A tax has a WL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus.

35 Summary The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher WLs. An increase in the size of a tax causes the WL to rise even more. An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market.

Chapter 8 Application: The Costs of Taxation

Chapter 8 Application: The Costs of Taxation Review Questions What three factors must be taken into account in order to fully understand the effect of taxes on economic well-being? ANSWER: In order to